Understanding how to evaluate the risk of your commercial property purchase or development is vital, and one of the most important parts of the process is underwriting.
Underwriting can be complicated, but it is also a crucial part of the property acquisition process.
Read Next: A Complete Guide to Common Commercial Real Estate Underwriting Terms & Definitions
In this article, we will explain the following, in order to enable you to better understand the underwriting process:
- What is underwriting?
- How is underwriting used in commercial real estate?
- How can you make underwriting easier?
What Is Underwriting?
Underwriting is the backbone of investment decisions in the financial world.
It is the process of establishing both the risk and potential return of all types of investments, whether it be a real estate investor purchasing a building, a bank issuing a loan, or an investment banker evaluating a stock.
Underwriting can take a number of forms, but the most common in commercial real estate is the use of financial modeling to project potential cash flows and the likelihood of those cash flows coming to fruition.
The inputs for these models will vary depending on the circumstances, but generally, variables like income and expenses will be considered, along with more advanced variables like discount rates and likelihoods of success.
In real estate, an analysis will usually start with a property’s gross potential income. You then subtract out variables like operating expenses and vacancy allowances to find the property’s net operating income (NOI), which can then be used in conjunction with a cap rate to find the property’s value.
Value = Net Operating Income / Cap Rate
How Underwriting Is Used in Commercial Real Estate
Entire books have been written on the general underwriting process, but for the purposes of this article, we will focus solely on how underwriting is utilized in the realm of real estate.
The Basics of Underwriting for Real Estate
When underwriting is used in real estate, it is generally used as a tool for evaluating the value of a building based on the building’s projected cash flows. commercial real estate investors will underwrite, or “model,” the prospective CRE investment in order to forecast the return that can be expected if the CRE investment is pursued.
The underwriting process is a key step and can be a deciding factor for whether an opportunity is pursued or passed on.
The type of underwriting conducted will also depend on the type of property being considered, including if the property is existing or is being developed.
Underwriting an Existing Building
A common way to model a commercial real estate investment is to project the building’s cash flows over a specific time horizon, usually the amount of time the CRE investor intends to hold the property.
The primary factors that you would need to input into the model are:
- the lease expirations of the current tenants during the hold period
- the renewal probability for the tenants with leases expiring
- the projected market rents for the building as the in-place leases expire
- the expected costs (tenant improvements, leasing commissions, and downtime) to renew the existing tenant or get the space released
Once the analyst has input the building’s potential income, expenses, and debt payments (if a loan will be used to make the purchase), the model can then be “stress-tested” to see how the commercial real estate investment is likely to perform in different scenarios.
Modeling in this way can be as simple or as complicated as you make it, but it is important to remember that the model is only as good as the data you put into it.
Underwriting a Development
The process of underwriting a potential development is similar to that of an existing building in that you are projecting the building’s cash flow over a specific time horizon.
For a development, predicting rents and cash flows two to three years into the future (the time typically required for permitting and construction) can be more challenging. The construction period requires upfront money before any income is generated, and leasing space to tenants before construction is complete, known as pre-leasing, is not always possible. If the building delivers with significant vacant space, it can be hard to accurately underwrite how quickly that space will be filled due to market factors like the strength of the economy and other availabilities in the market.
It is very important to have accurate budgets and timelines, as cost overruns and delays in construction can add up quickly and hurt returns. It is also important to make sure that you account for the time required to get your development site permitted through the city, as this process can often take upwards of 12 months.
Securing a Loan
When investing in commercial real estate, CRE investors typically work with a lender to receive a loan for the purchase of the building. There are several different types of institutions that provide loans on real estate assets, ranging from local banks to life insurance companies and large debt funds. Each lender will have its own underwriting process to evaluate the CRE investment and to make a determination of whether to issue the loan and under what terms the loan will be given.
The lender will look at the property in a similar way as the commercial real estate investor to estimate what likely cash flows can be anticipated. However, the bank will also evaluate the borrower’s creditworthiness and factor that into the decision-making, as the lender will expect the borrower to continue making the debt service payments in the event there are ever any shortfalls from the building’s cash flow.
Typically, banks will give a loan equal to a percentage of the value they place on the property. Depending on the type of CRE investment, the borrower, and the type of financial institution issuing the loan, the “Loan To Value” typically ranges between 50% to 80% of the building’s total value.
Loan Amount = Loan To Value % x Assessed Value
It is important to remember that the value the lender places on the building is independent of the purchase price. This means that when underwriting a property for purchase, it is always a good idea to begin talking to a lender as soon as possible to accurately underwrite the amount of equity that will be required for the acquisition.
Equity Required = Purchase Amount – Loan Amount
How to Make Underwriting More Efficient
Unless you are a real estate expert and have experience with financial modeling, trying to tackle underwriting on your own can be an almost impossible task. The smallest of errors can have a large impact on the accuracy of the projections and result in expensive consequences.
Because of this, we highly recommend leveraging the skills of a commercial real estate investment sales broker or analyst to handle the underwriting process for you.
If you are already in the process of evaluating potential commercial real estate investments with a broker, he or she will likely be able to build the CRE investment model for you and walk you through the analysis.
Don’t have a Commercial real estate investment broker? Talk to one of our experts today.
From identifying opportunities to underwriting the project, our commercial real estate investment services brokers are ready to help you with your next Austin commercial real estate investment.
By enlisting a broker to assist you with the underwriting process, you will be able to focus on the commercial real estate investment itself and evaluate the results of the model rather than spending time and energy building the model itself.
We hope this article gave you a better understanding of underwriting and answered some questions you may have had. If you would like help underwriting your own commercial real estate investment, give our experienced commercial real estate investment services team a call today.
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